Structuring the Deal: Payment and Legal Considerations
Abstract
This chapter introduces the deal structuring process and the interrelatedness of the factors that comprise the process. The focus in this chapter is on the form of payment (e.g., cash, stock, etc.), form of acquisition (e.g., assets or stock), and alternative forms of legal structures in which ownership is conveyed (e.g., mergers and special cases), as well as common postclosing organizations (e.g., holding companies) created to operate the acquired firm. How risk can be managed (e.g., collar arrangements) and consensus reached on purchase price also are discussed in detail as is the use of option and warrant takeover strategies. The chapter also addresses the potential for using cryptocurrencies as a form of payment.
Keywords
Deal structuring; M&A deal structuring; Form of payment; Form of acquisition; Mergers; Acquisitions; Share exchange ratio; Floating share exchange ratio; Fixed share exchange ratio; Alternative legal structures; Acquisition vehicle; Convertible securities; Balance sheet adjustment; Earnouts; Contingent provisions; Contingent value rights; Collar arrangements; Purchase of assets; Purchase of stock; Statutory mergers; Merger of equals; Bitcoin; Cryptocurrencies; Digital currency; Block chain
If you can’t convince them, confuse them.
Harry S. Truman
Inside M&A: Getting to Yes on Price
After a grueling 6 months, Houston Texas based Westlake Chemical (Westlake) sealed the deal it had so aggressively sought by acquiring polyvinyl chloride (PVC) producer Axiall Corp (Axiall). The combination created the second largest PVC manufacturer in North America and the third largest chlor-alkali producer. At $33 per share, the all-cash deal valued Axiall’s equity at $2.4 billion; including assumed debt of $1.4 billion, the enterprise value rose to $3.8 billion. Westlake saw Axiall as key to its growth strategy by giving Westlake greater scale, cost and revenue synergies, and a better balance between its olefins and vinyl’s businesses. Anticipated synergies are expected to reach $100 million annually by the fourth year following closing.
When Westlake’s initial merger proposal was rejected on January 22, 2016, the friendly bid deteriorated into a hostile takeover attempt. Westlake threatened a proxy battle to remove Axiall’s entire board, as Axiall searched for a White Knight to counter Westlake. The negotiation was characterized by a series of bids and counterbids amid an auction atmosphere. Axiall shareholders saw the January 21st closing price for their stock balloon by almost 250% by the time an agreement was reached on June 10th.
What follows is a description of events that transpired between Westlake and Axiall during their lengthy takeover battle which ended in a signed merger agreement and Westlake withdrawing its slate of candidates to replace the Axiall board. These events illustrate common negotiating tactics used by potential acquirers and target boards and senior managers to hammer out M&A agreements.1
In August 2015, Axiall announced publicly that it was initiating a strategic review of its building products business as part of a general strategy to become a more focused company. The announcement almost immediately triggered interest by others to buy the entire company. As interest grew, Timothy Mann, Axiall’s President and CEO, rebuffed a potential bidder in early October 2015 saying that the timing was not right. But these actions had set in motion a chain of events that would ultimately result in the sale of Axiall.
On January 21, 2016, Albert Chao, Westlake’s President and CEO, contacted Mr. Mann requesting a meeting in which Westlake offered to acquire Axiall for $20 per share consisting of $11 in cash and 0.1967 of a share of Westlake common stock. Westlake confirmed its proposal in a letter requesting a response by January 28th.
Axiall’s board met on January 27th along with their financial and legal advisors. The board instructed Mr. Mann to tell Westlake’s Mr. Chao that they would not engage in further talks on the basis of Westlake’s initial proposal. Within two weeks, Westlake notified Axiall and publicly disclosed that it had nominated a slate of directors to replace Axiall’s entire board. In early March, Axiall instructed its financial advisors to contact other potential bidders. At the same time, the board authorized Mr. Mansfield, Axiall’s Chairman of the Board, and an independent board member to contact Westlake’s Mr. Chao for a meeting to outline a process for further discussing Westlake’s proposal. In that meeting, Axiall’s representatives informed Mr. Chao that their board was willing to sign a confidentiality agreement and provide Westlake with proprietary information. The intent of the release of such information was to convince Westlake that Axiall was worth more, much more.
By mid-March, the two firms signed a confidentiality agreement with standstill provisions permitting Westlake to make acquisition proposals and to pursue the election of individuals it had nominated to serve on Axial’s board. However, the agreement prohibited Westlake from acquiring Axiall stock or making a tender offer for Axiall shares before September 15, 2016. For the next two weeks, Westlake conducted limited due diligence on Axiall. Simultaneously, Axiall’s board through its financial advisors contacted eight potentially interested parties, allowing three of the potential buyers to perform due diligence.
On March 29th, Westlake submitted a revised proposal increasing the cash portion of the consideration to $14 per share while keeping the stock portion unchanged at 0.1967 of a share of Westlake stock per share of Axiall stock. The stock portion of the bid was valued at $9.15 based on Westlake’s closing share price on March 28th. The new bid was valued at $23.15 per share of Axiall stock. Axiall’s board rejected this latest bid as inadequate but said they would be willing to negotiate a merger agreement at above $30 per share.
On June 3rd, Westlake revised its second offer to an all-cash offer of $25.75 per share. At the same time, an unidentified bidder submitted a cash offer of $28 per share. In response, Westlake increased its offer to $30.50 per share in cash. The unidentified bidder upped its bid to $31 per share, which Westlake countered with a cash bid of $33 per share on June 9th. Axiall also consented to setting the termination fee it would pay to back out of the day based on certain conditions stipulated in the contract to 3.25% of the equity value of the deal (versus Westlake’s demand for 3.5%) or $77 million.
With its advisors recommending acceptance, Axiall’s board subsequently voted unanimously to approve Westlake’s fourth offer stating that it was fair and in the best interests of Axiall’s shareholders. The final Westlake bid represented a 244% premium to the closing price of $9.60 on January 22nd, the last full trading day before Westlake made its initial proposal to Axiall. Indeed, getting to yes on price proved very lucrative for Axiall’s shareholders.
Chapter Overview
Once management has determined that an acquisition is the best way to implement the firm’s business strategy, a target has been selected, and the preliminary financial analysis is satisfactory, it is time to consider how to structure the deal. A deal structure is an agreement between two parties (the acquirer and the target firms) defining their rights and obligations. The way in which this agreement is reached is called the deal-structuring process. In this chapter, this process is described in terms of seven interdependent components: acquisition vehicle, the postclosing organization, the form of payment, the legal form of the selling entity, form of acquisition, accounting considerations, and tax considerations.
The focus in this chapter is on the form of payment, the form of acquisition, and alternative forms of legal structures in which ownership is conveyed and how they interact to impact the overall deal. The implications of alternative tax structures, how deals are recorded for financial-reporting purposes, and how they might affect the deal-structuring process are discussed in detail in Chapter 12. A review of this chapter is available in the file folder entitled “Student Study Guide” on the companion website to this book https://www.elsevier.com/books-and-journals/book-companion/9780128150757.
The Deal-Structuring Process
The deal-structuring process involves satisfying as many of the primary acquirer and target objectives as possible, determining how risk will be shared, and identifying the rights and obligations of parties to the deal. The process may involve multiple parties, approvals, forms of payment, and sources of financing. Decisions made in one area often affect other areas of the deal. Containing risk associated with a complex deal is analogous to squeezing one end of a water balloon, which simply forces the contents to shift elsewhere.
Key Components of the Deal-Structuring Process
The process begins with addressing a set of key questions, shown on the left-hand side of Fig. 11.1. Answers to these questions help define initial negotiating positions, potential risks, options for managing risk, levels of tolerance for risk, and conditions under which either party will “walk away” from the negotiations. The key components of the process are discussed next.
The acquisition vehicle refers to the legal structure created to acquire the target company. The postclosing organization, or structure, is the organizational and legal framework used to manage the combined businesses following the consummation of the transaction. Common acquisition vehicles and postclosing organizations include the corporate, division, holding company, joint venture (JV), partnership, limited liability company (LLC), and employee stock ownership plan (ESOP) structures. Although the two structures are often the same before and after completion of the transaction, the postclosing organization may differ from the acquisition vehicle, depending on the acquirer’s strategic objectives for the combined firms.
The form of payment, or total consideration, may consist of cash, common stock, debt, or a combination of all three types. The payment may be fixed at a moment in time, contingent on the target’s future performance, or payable over time. The form of acquisition reflects what is being acquired (stock or assets) and how ownership is conveyed. Accounting considerations address the impact of financial reporting requirements on the future earnings of the combined businesses. Tax considerations entail tax structures that determine whether a deal is taxable or nontaxable to the seller’s shareholders. The legal form of the selling entity also has tax implications.
Common Linkages
Fig. 11.1 explains through examples common interactions among various components of the deal structure. These are discussed in more detail later in this chapter and in Chapter 12.
Form of Payment (Fig. 11.1, Arrows 1 and 2) Affects Choice of Acquisition Vehicle and Postclosing Organization
The buyer may offer a purchase price contingent on the future performance of the target and choose to acquire and operate the target as a wholly owned subsidiary within a holding company during the term of the earnout (deferred payout). This facilitates monitoring the operation’s performance and minimizes possible postearnout litigation.
Effects of Form of Acquisition (Fig. 11.1, Arrows 3–6)
Choice of acquisition vehicle and postclosing organization: If the form of acquisition is a statutory merger, all liabilities transfer to the buyer, who may acquire and operate the target within a holding company to provide some protection from the target’s liabilities.
Form, timing, and amount of payment: The assumption of all seller liabilities in a merger or stock purchase may cause the buyer to alter the terms of the deal to include more debt or installment payments, to reduce the present value of the purchase price, or both.
Tax considerations: The transaction may be tax free to the seller if the acquirer uses its stock to acquire substantially all of the seller’s assets or stock.
Effects of Tax Considerations (Fig. 11.1, Arrows 7 and 8)
Amount, timing, and composition of the purchase price: If the deal is taxable to the target shareholders, the purchase price often is increased to offset the target shareholders’ tax liability. The higher purchase price could alter the composition of the purchase price as the buyer defers a portion of the price or includes more debt to lower its present value.
Selection of postclosing organization: The desire to minimize taxes encourages the use of S-corporations, LLCs and partnerships to eliminate double taxation; tax benefits also pass through to LLC members and partners in partnerships. By 2011, 54% of business income was earned by pass through firms, up from 21% in 1980.
Legal Form of Selling Entity (Fig. 11.1, Arrow 9) Affects Form of Payment
Because of the potential for deferring shareholder tax liabilities, target firms qualifying as C corporations often prefer to exchange their stock or assets for acquirer shares. Owners of S corporations, LLCs, and partnerships are largely indifferent to a deal’s tax status because the proceeds of the sale are taxed at the owners’ ordinary tax rate.
Accounting Considerations (Fig. 11.1, Arrow 10) Affect Form, Amount, and Timing of Payment
The requirement to adjust more frequently the fair value of contingent payments may make earnouts less attractive as a form of payment due to the potential increase in earnings volatility. Equity as a form of payment may be less attractive due to the potential for changes in its value between the deal announcement date and closing date. The potential for future write-downs may discourage overpayment by acquirers due to the required periodic review of fair market versus book values. Table 11.1 provides a summary of these common linkages.
Table 11.1
| Component of deal-structuring process | Influences choice of: |
|---|---|
| Form, amount, and timing of payment | Acquisition vehicle Postclosing organization Accounting considerations Tax structure (taxable or nontaxable) |
| Form of acquisition | Acquisition vehicle Postclosing organization Form, amount, and timing of payment Tax structure (taxable or nontaxable) |
| Tax considerations | Form, amount, and timing of payment Postclosing organization |
| Legal form of selling entity | Tax structure (taxable or nontaxable) |
Form of Acquisition Vehicle and Postclosing Organization
Choosing an acquisition vehicle or postclosing organization requires consideration of the cost and formality of organization, ease of transferring ownership, continuity of existence, management control, ease of financing, ease of integration, method of distribution of profits, extent of personal liability, and taxation. Each form of legal entity has different risk, financing, tax, and control implications for the acquirer. The selection of the appropriate entity can help to mitigate risk, maximize financing flexibility, and minimize the net cost of the acquisition.
Choosing the Appropriate Acquisition Vehicle
The corporate structure is the most commonly used acquisition vehicle, since it offers limited liability, financing flexibility, continuity of ownership, and deal flexibility (e.g., option to engage in a tax-free deal). For small privately owned firms, an employee stock ownership plan structure may be a convenient way for transferring the owner’s interest to the employees while offering tax advantages. Non-US buyers intending to make acquisitions may prefer a holding company structure, enabling the buyer to control other companies by owning only a small portion of the company’s voting stock. A partnership may be appropriate if it is important to share risk, to involve partners with special attributes, to avoid double taxation, or in special situations.2
Choosing the Appropriate Postclosing Organization
The postclosing organization can be the same as that chosen for the acquisition vehicle. Common postclosing structures include divisional3 and holding company arrangements. While holding companies are often corporations, they also represent a distinct way of organizing and operating the firm. The choice of postclosing organization depends on the objectives of the acquirer. The acquiring firm may choose a structure that facilitates postclosing integration, minimizes risk from the target’s known and unknown liabilities, minimizes taxes, passes through losses to shelter the owners’ tax liabilities, preserves unique target attributes, maintains target independence during the duration of an earnout, or preserves the tax-free status of the deal.
If the acquirer intends to integrate the target immediately after closing, the corporate or divisional structure often is preferred because it offers the greatest control. In JVs and partnerships, the dispersed ownership may render decision making slower or more contentious. Implementation is more likely to depend on close cooperation and consensus building, which may slow efforts at rapid integration of the acquired company. Realizing synergies may be more protracted than if management control is more centralized within the parent.
A holding company structure may be preferable when the target has significant liabilities, an earnout is involved, the target is a foreign firm, or the acquirer is a financial investor. The parent may be able to isolate target liabilities within the subsidiary, and the subsidiary could be forced into bankruptcy without jeopardizing the parent. When the target is a foreign firm, operating it separately from the rest of the acquirer’s operations may minimize disruption from cultural differences. Finally, a financial buyer may use a holding company structure because the buyer has no interest in operating the target firm for any length of time. A partnership or JV structure may be appropriate if the risk and the value of tax benefits are high. The acquired firm may benefit because of the expertise that the different partners or owners might provide. A partnership or LLC eliminates double taxation and passes current operating losses, tax credits, and loss carryforwards and carrybacks to the owners.
Legal Form of the Selling Entity
Seller concerns about the form of the transaction may depend on whether it is an S corporation, a limited liability company, a partnership, or a C corporation. C corporations are subject to double taxation, whereas owners of S corporations, partnerships, and LLCs are not (see Exhibit 11.1).
Form of Payment
The fraction of all-stock deals peaked in the late 1990s at more than 60% before plunging in recent years to about 20%. In contrast, all-cash deals bottomed out at about 25% in the late 1990s before rising to about 50% in recent years. Mixed payment deals (i.e., those involving both stock and cash) have risen from about 10% in the late 1990s to about 30% most recently.4 This section addresses the different forms of payment used and the circumstances in which one form may be preferred over another.
Cash
Acquirers may use cash if the firm has significant borrowing capacity, a high credit rating, undervalued shares and wishes to maintain control, and if the target is unionized. Surprisingly, there is little correlation between the size of an acquirer’s cash balances and the likelihood it would make a cash offer in a takeover. In fact, cash rich acquirers are often more likely to make stock rather than cash offers than acquirers with smaller cash holdings. This seeming anomaly may reflect the target’s preference for acquirer stock due to its perceived growth potential or for a tax-free deal.5 A cash purchase is more likely to be financed from borrowing if the firm has a high credit rating due to its comparatively low borrowing costs.6 Highly leveraged acquirers are less likely to offer all-cash deals and more likely to pay less cash in mixed payment offers consisting of cash and stock. Undervalued shares could result in substantial dilution of the acquirer’s current shareholders. A bidder may use cash rather than shares if the voting control of its dominant shareholder is threatened as a result of the issuance of voting stock to acquire the target.7 Finally, acquirers are more likely to use cash as the dominant form of payment when the target is unionized. The use of excess cash on the balance sheet or from borrowing reduces the acquirer’s financial flexibility and enables them to take a tougher position to gain concessions during postacquisition bargaining.8
The preference for using cash appears to be much higher in Western European countries, where ownership tends to be more heavily concentrated in publicly traded firms, than in the United States. In Europe, 63% of publicly traded firms have a single shareholder directly or indirectly controlling 20% or more of the voting shares; the US figure is 28%.9 The seller’s shareholders may prefer cash if they believe the acquirer’s shares have limited appreciation potential and have a high tax basis in their stock.10 The high basis implies lower capital gains and less need to defer the payment of taxes.
Noncash
The use of stock is more complicated than cash because of the need to comply with prevailing securities laws. An acquirer having limited borrowing capacity may choose to use stock if it is believed to be overvalued and when the integration of the target firm is expected to be lengthy in order to minimize the amount of indebtedness required to complete the takeover. By maintaining the ability to borrow, the acquirer is able to finance unanticipated cash outlays during the integration period and to pursue investment opportunities that might arise.
Acquirer stock may also be a useful form of payment when valuing the target firm is difficult, such as when the target has hard-to-value intangible assets, new products, or large R&D outlays. In accepting acquirer stock, a seller may have less incentive to negotiate an overvalued purchase price if it wishes to participate in any appreciation of the stock it receives.11 For similar reasons, the use of stock may be particularly beneficial in a cross-border deal in which there is little reliable information about the target and existing management is subject to conflicts of interest.12 Other forms of noncash payment include real property, rights to intellectual property, royalties, earnouts, and contingent payments.
Sellers often demand acquirer shares as the primary form of payment due to the ability to defer the payment of taxes. Acquirer shares might be especially attractive if their growth prospects are favorable.13 There is the ever present danger to selling shareholders that the acquirer shares may be overvalued and decline in value over time toward their true value.14 Seller shareholders may find debt unattractive because of the acquirer’s perceived high risk of default. Debt or equity securities issued by nonpublic firms may also be illiquid because of the small size of the resale market for such securities.
Acquirers, such as small or emerging firms, may not have access to relatively inexpensive debt financing. As such, they may be inclined to finance their cash bids for targets by issuing equity. Because equity is a higher cost source of financing, its use to finance the cash bid can result in lower purchase price premiums. In contrast, acquirers having access to inexpensive debt financing are prone to borrow to finance their cash bids and tend to overbid for target firms.15
Cash and Stock in Combination
Offering target shareholders multiple payment options may encourage more participation in tender offers. Some target shareholders want a combination of acquirer stock and cash if they are unsure of the appreciation potential of the acquirer’s stock. Others may prefer a combination of cash and stock if they need the cash to pay taxes due on the sale of their shares. Also, acquirers, unable to borrow to finance an all-cash offer or unwilling to absorb the dilution in an all-stock offer, may choose to offer the target firm a combination of stock and cash.
Acquirers also may be motivated to offer their shares if they believe they are overvalued, since they are able to issue fewer shares. Target firm shareholders may be willing to accept overvalued acquirer shares because the overvaluation may not be obvious or the acquirer stock may reduce the degree of postmerger leverage of the combined firms.16 If investors believe the combined firms are less risky because of the reduction in leverage, the intrinsic value of the acquirer shares may rise reflecting the combined firm’s lower cost of capital. The resulting rise in their intrinsic value may reduce or eliminate the overvaluation of the acquirer shares.
The multiple-option bidding strategy creates uncertainty, since the amount of cash the acquirer ultimately will have to pay to target shareholders is unclear, because the number of shareholders choosing the all-cash or cash-and-stock option is not known prior to completion of the tender offer. Acquirers resolve this issue by including a proration clause in tender offers and merger agreements that allows them to fix—at the time the tender offer is initiated—the amount of cash they will ultimately have to pay out.17
Convertible Securities
An acquirer and a target often have inadequate information about the other, even after completing due diligence. The acquirer is anxious about overpaying, and target shareholders are concerned about the offer price reflecting the fair value of their shares. Using acquirer stock as the primary form of payment may mitigate some of this concern because target shareholders hoping to participate in any future appreciation are less likely, so goes the theory, to withhold important information. However, this does not address the issue of the fairness of the purchase price to target shareholders.
Convertible securities18 offer the potential of resolving the concerns of the acquirer and the target when both are lacking in critical information about the other. Bidders believing their shares are undervalued are reluctant to use stock, to avoid diluting their current shareholders. To communicate their belief, such bidders may offer convertible debt as a form of payment. Target shareholders may find such offers attractive, because they provide a floor equal to the value of the debt at maturity plus accumulated interest payments as well as the potential for participating in future share appreciation. Bidders believing their shares are overvalued are more inclined to offer stock rather than cash or convertible securities. If the convertible securities are unlikely to be converted due to the limited share price appreciation of the bidder’s stock, the securities will remain as debt and burden the firm with substantial leverage. There is empirical evidence that the use of convertible securities when both parties are lacking information can benefit both the bidder and the seller. Bidder and target abnormal announcement date returns for such deals are 1.86% and 6.89%, respectively.19
Cryptocurrency: Fiction Versus Reality
Cryptocurrencies are digital monies using cryptography (i.e., the scrambling of data to make it unreadable) to make transactions secure, verify the transfer of funds, and to control the creation of additional units. Powered by its underlying block chain technology,20 Bitcoin is the best known of the more than 1000 cryptocurrencies in existence in late-2018.21 Users trade Bitcoin over a network of decentralized computers eliminating intermediaries such as governments, commercial banks, and central banks. Bitcoin enables users to avoid transaction fees incurred if the banking system had been used to complete transactions and to eliminate currency conversion costs in international transactions, all done in relative secrecy. Bitcoin is difficult to counterfeit and may enable immediate verifiable payment in M&A deals.
Many, if not most, observers might classify themselves at the time of this writing as “cryptocurrency-skeptics.” This is understandable given the wild gyrations in the price of cryptocurrencies. Furthermore, the costs of acquiring and liquidating Bitcoin represent barriers to using it as a form of payment. The lack of price stability when compared to government fiat currencies undermines confidence in using this form of payment in M&As without some type of a collar arrangement within which the value of the purchase price can fluctuate. Alternatively, Bitcoin if traded on a futures exchange could be hedged against loss of value by buying a futures contract locking in the current price, although this would add to transaction costs.
There also are concerns about security, with several instances of theft of Bitcoin by hackers. Other issues include the general lack of regulation and transparency. Government taxing authorities, concerned with the accuracy of the sale price reported for tax purposes, might be quick to audit those involved in Bitcoin financed M&A deals. Some portion of Bitcoin proceeds from any deal would have to be converted to fiat currency to pay any taxes owed. Money laundering also is a potential concern to governments. Monies obtained from criminal activities can be used to buy Bitcoin which could then be used to acquire a legitimate business.
Could there be a role for cryptocurrency as a form of payment in M&As? Yes, if concerns about security, volatility, and transparency can be overcome. Until then, cash and securities are likely to remain the primary form of payment in M&As. While cryptocurrencies have the potential to either revolutionize financial markets or to become a quaint footnote in history books, they do merit watching.
Managing Risk and Reaching Consensus on Purchase Price
Someone once said “you name the price and I will name the terms.” While the purchase price is just a number, the form and the timing of the payment as well as concessions made to the other party refer to the terms. In other words, if the parties to the negotiation are motivated to close the deal, just about any deal can get done. Balance-sheet adjustments and escrow accounts; earnouts; contingent value rights; rights to intellectual property and licensing fees; and consulting agreements may be used to close the deal when the buyer and seller cannot reach agreement on price. These are discussed next.
Postclosing Balance-Sheet Price Adjustments and Escrow Accounts
About four-fifths of M&As require some purchase price adjustment, resulting most often from a restatement of operating earnings or cash flow or working capital.22 Escrow or holdback accounts and adjustments to the target’s balance sheet are most often used in cash rather than stock-for-stock purchases (particularly when the number of target shareholders is large). They rely on an audit of the target firm to determine its “true or fair” value and are applicable only when what is being acquired is clearly identifiable, such as in a purchase of tangible assets. With escrow accounts, the buyer retains a portion of the purchase price until completion of a postclosing audit of the target’s financial statements. Escrow accounts may also be used to cover continuing claims beyond closing.
Balance-sheet adjustments are used when the elapsed time between the agreement on price and the actual closing date is lengthy. The balance sheet may change significantly, so the purchase price is adjusted up or down. Such adjustments can be used to guarantee the value of the target firm’s shareholder equity or, more narrowly, the value of working capital. With a shareholder equity guarantee, both parties agree at signing to an estimate of the target’s equity value on the closing date. The purchase price is then increased or decreased to reflect any change in the book value of the target’s equity between the signing and closing dates due to net profit earned (or lost) during this period. Agreement may be reached more easily between the buyer and the seller with a working capital guarantee, which ensures against changes in the firm’s net current operating assets.23 As Table 11.2 indicates, the buyer reduces the total purchase price by an amount equal to the decrease in net working capital or shareholders’ equity of the target and increases the purchase price by any increase in these measures during this period.
Earnouts and Other Contingent Payments
Earnouts and warrants often are used whenever the buyer and the seller cannot agree on price or when the parties involved wish to participate in the upside potential of the business. Earnout agreements may also be used to retain and motivate key target firm managers. An earnout agreement is a financial contract whereby a portion of the purchase price of a company is to be paid in the future, contingent on realizing the future earnings level or some other performance measure agreed on earlier. A subscription warrant, or simply warrant, is a type of security—often issued with a bond or preferred stock—that entitles the holder to purchase an amount of common stock at a stipulated price. The exercise price is usually higher than the price at the time the warrant is issued. Warrants may be converted over a period of many months to many years.
The earnout typically requires that the acquired business be operated as a wholly owned subsidiary of the acquiring company under the management of the former owners or key executives.24 Earnouts differ substantially in terms of the performance measure on which the contingent payout is based, the period over which performance is measured, and the form of payment for the earnout.25 Some earnouts are payable only if a certain threshold is achieved; others depend on average performance over several periods. Still others may involve periodic payments, depending on the achievement of interim performance measures rather than a single, lump-sum payment at the end of the earnout period. The value of the earnout is often capped. In some cases, the seller may have the option to repurchase the company at some predetermined percentage of the original purchase price if the buyer is unable to pay the earnout at maturity.
Earnouts consist of two parts: a payment up front and a deferred payment. The initial payment must be large enough to induce the target firm shareholders to enter into the agreement and the deferred payment must be of sufficient size to keep them motivated to exceed agreed upon performance measures. Relatively large deferred payments and longer earnout periods are associated with higher takeover premia paid at closing than the premia paid in comparable nonearnout deals. Why? Target firm shareholders in earnouts are compensated for sharing the postacquisition integration risk with the acquiring firm by receiving a higher premium than they would have received had they received the entire payment upfront.26
Exhibit 11.2 illustrates how an earnout formula could be constructed reflecting these considerations. The purchase price has two components. At closing, the seller receives a lump-sum payment of $100 million. The seller and the buyer agree to a baseline projection for a 3-year period and that the seller will receive a fixed multiple of the average annual performance of the acquired business in excess of the baseline projection. Thus, the earnout provides an incentive for the seller to operate the business as efficiently as possible.27 By multiplying the anticipated multiple investors will pay for operating cash flow at the end of the 3-year period by projected cash flow, it is possible to estimate the potential increase in shareholder value.28
Exhibit 11.2
Hypothetical Earnout as Part of the Purchase Price
Purchase Price
- 1. Lump-sum payment at closing: The seller receives $100 million.
- 2. Earnout payment: The seller receives four times the excess of the actual average annual net operating cash flow over the baseline projection after 3 years, not to exceed $35 million.
| Base year (first full year of ownership) | |||
|---|---|---|---|
| Year 1 | Year 2 | Year 3 | |
| Baseline projection (net cash flow) | $10 | $12 | $15 |
| Actual performance (net cash flow) | $15 | $20 | $25 |
Earn-out at the end of 3 yearsa:
Potential increase in shareholder valueb:
Used in about 3% of US deals, earnouts are more common when the targets are small private firms or subsidiaries of larger firms rather than large publicly traded firms. Such contracts are more easily written and enforced when there are relatively few shareholders. Earnouts are most common in high-tech and service industries, when the acquirer and target firms are in different industries, when the target firm has a significant number of assets not recorded on the balance sheet, when buyer access to information is limited, and when little integration will be attempted. Earnouts are unpopular in countries which have relatively lax enforcement of contracts.29
Earnouts on average account for 45% of the price paid for private firms and 33% for subsidiary acquisitions, and target firm shareholders tend to realize about 62% of the potential earnout amount. In deals involving earnouts, acquirers earn abnormal returns, ranging from 1.5%30 to 5.4%,31 around the announcement date, much more than deals not involving earnouts. Positive abnormal returns to acquirer shareholders may be a result of investor perception that, with an earnout, the buyer is less likely to overpay and more likely to retain target firm talent.
Sometimes a seller will not agree to a conventional earnout structure in which a portion of the purchase price is withheld and paid to the seller after closing only if certain performance targets are met. A variation of the earnout structure that may be acceptable to both the seller and buyer is the reverse earnout. In this payment structure, rather than withholding some of the purchase price, the seller receives the entire amount at closing and must reimburse the earnout portion of the purchase price if it fails to achieve agreed upon postdeal targets. Reverse earnouts are less common since buyers in this arrangement must shoulder the risk. Just as conventional earnouts are difficult to enforce, the same is true with the reverse earnout. If the buyer disputes that the goal was not met, the onus is on the buyer, not the seller, to provide proof and the seller has already been paid the full earnout portion of the purchase price.
The allure of earnouts is their potential for bridging valuation gaps. While they can enable the two parties to reach agreement in order to close the deal, unless properly structured they simply convert today’s agreement into tomorrow’s litigation. Several Delaware Chancery Court decisions provide some guidance on issues that commonly arise in earnouts.
In an earnout dispute resulting from Gilead’s 2011 takeover of Calistoga Pharmaceuticals, Gilead was required to pay Calistoga a $50 million milestone payment even though the European regulatory approval for the patent application was much narrower than anticipated and would generate much less revenue. Gilead argued that it was logical to assume that the earnout milestone was based on a broader rather a narrower application of the drug. The court ruled in favor of the seller stating that the definition of the milestone was ambiguous.
A second ruling dealt with Valeant Pharmaceuticals International’s takeover of Sprout Pharmaceuticals in 2015. The ruling related to implied covenants (i.e., those not explicitly stated in the contract but assumed to be true by all parties to the contract). The most common example of an implied covenant is that of “good faith and fair dealing” in which it is assumed the parties to the contract will deal with each other in an honest manner and not resort to misleading statements during negotiations. Sprout alleged that Valeant’s high pricing of an acquired drug, while not contrary to any conditions stipulated in the contract, violated the implied covenant of good faith. Why? The prices of the drugs were so high as to be unreasonable and therefore caused sales to be lower than anticipated. The ruling resulted in Valeant having to pay Sprout the full earnout payment stipulated in the sales agreement.
The key takeaways from these court cases are that terms in the contract should be as clearly defined as possible and illustrated by as many examples as practical to avoid ambiguity. To minimize the risk of implied covenants overriding contract language, contract provisions should be as inclusive as possible (e.g., the buyer should make all reasonable efforts to help the seller achieve agreed upon milestones), examples illustrating various situations should be used, and language in the agreement should state that contract provisions supersede implied covenants.
Even when earnouts are properly constructed and offer substantial financial incentives for those they affect, they can still fail to reach their intended objectives. In a much publicized breakup in April 2018, Jan Koum (founder of Whatsapp) quit over the placement of advertising on the messaging service. In doing so, Koum may have walked away from billions in unvested restricted Microsoft stock options, although the amount is unclear. And Facebook failed to retain Koum who they had viewed as critical to the operation when it acquired the firm for an eye popping $19 billion in 2014.
Contingent Value Rights
Contingent value right (CVR) securities issued by the acquirer commit it to pay additional cash or securities to the holder of the CVR (i.e., the seller) if the acquirer’s share price falls below a specified level at some future date. They can be traded on public exchanges. Their use suggests that the acquirer believes that its shares are unlikely to fall below their current level. CVRs are sometimes granted when the buyer and the seller are far apart on the purchase price. A CVR is more suitable for a public company or a private firm with many shareholders than is an earnout, because it can be transferred to many investors. Earnouts are more often used with sales of private firms rather than for sales of public firms, since they are designed to motivate a firm’s managers who have a significant degree of control over the firm’s future performance.32
There are two basic types of CVRs: those offering price protection and those that are triggered by an event or achieving a milestone. Price protected CVRs offer seller shareholders additional cash if the buyer’s shares they received as part of the deal fail to achieve certain price levels within a certain time period. They can be used when acquirer stock is the dominant form of payment. CVRs triggered by an event are more commonplace and offer additional cash if certain events are achieved. Events that can trigger the CVR include the beginning of patent testing, regulatory approval, and satisfying certain commercial sales thresholds.
An important benefit of CVRs is that they can be customized to the needs of the parties involved in the transactions. However, they have significant shortcomings due to their complexity and potential liability. The former may involve the potential for multiple layers of triggers and detailed definitions, while the latter reflects their significant litigation risk.
Drug companies frequently use CVRs as a portion of the payment made to acquire other drug companies, whose products do not have a proven track record, to reduce the risk of overpaying. In 2016, Irish drug manufacturer paid US biotechnology firm Dyax Corporation shareholders $37.30 per share in cash at closing. Dyax shareholders would also receive an additional cash payment of $4 per share if the firm’s leading treatment drug for hereditary angeioedema, DX-2930, received approval by the Federal Drug Administration approval by the end of 2019.
In 2016, potential conflicts of interest associated with CVRs were highlighted in a shareholder lawsuit against French Pharmaceutical firm, Sanofi, which acquired Genzyme, a US-based biotech firm, in 2011 for $20 billion. Genzyme had been conducting clinical trials for a promising multiple sclerosis treatment called Lemtrada and estimated the value of each CVR at $5.58. The merger contract required Sanofi to make “diligent efforts” to guide Lemtrada through the US Federal Drug Administration regulatory process and to “ignore any cost of potential CVR payments.” The merger agreement, however, did not address the potential conflict arising from Sanofi developing its own multiple sclerosis drug, Aubagio, which would compete with Lemtrada. The lawsuit alleges Sanofi focused on developing Aubagio to avoid making as much as $3.8 billion in payments to CVR holders. After 1 year on the market, Lemtrada generated sales of about $37 million, less than one-fifth of the approximate $180 million realized by Aubagio in its first year on the market. By the end of 2016, the CVRs traded at $.14.
Rights, Royalties, and Fees
Intellectual property, royalties from licenses, and fee-based consulting or employment contracts are other forms of payment used to resolve price differences between the buyer and the seller. The right to use a proprietary process or technology for free or at a below-market rate may interest former owners considering other business opportunities.33 Such arrangements should be coupled with agreements not to compete in the same industry as their former firm. Table 11.3 summarizes the advantages and disadvantages of these various forms of payment.
Table 11.3
| Form of payment | Advantages | Disadvantages |
|---|---|---|
| Cash (including highly marketable securities) | Buyer: Simplicity. | Buyer: Must rely solely on protections afforded in the contract to recover claims. |
| Seller: Ensures payment if acquirer’s creditworthiness is questionable. | Seller: Creates immediate tax liability. | |
| Stock – Preferred – Convertible preferred | Buyer: High P/E relative to seller’s P/E may increase the value of the combined firms if investors apply higher P/E to combined firms’ earnings. | Buyer: Adds complexity; potential EPS dilution. |
| Seller: Defers taxes and provides potential price increase. Retains interest in the business. | Seller: Potential decrease in purchase price if the value of equity received declines. May delay closing because of SEC registration requirements. | |
| Debt – Unsecured – Convertible | Buyer: Interest expense is tax deductible. | Buyer: Adds complexity and increases leverage. |
| Seller: Defers tax liability on the principal. | Seller: Risk of default. | |
| Performance-related earnouts | Buyer: Shifts some portion of the risk to the seller. | Buyer: May limit the integration of the businesses. |
| Seller: Potential for a higher purchase price. | Seller: Increases the uncertainty of the sales price. | |
| Purchase price adjustments | Buyer: Protection from eroding values of working capital before closing. | Buyer: Audit expense. |
| Seller: Protection from increasing values of working capital before closing. | Seller: Audit expense. (Note that buyers and sellers often split the audit expense.) | |
| Real property – Plant and equipment – Business or product line | Buyer: Minimizes use of cash. | Buyer: Opportunity cost. |
| Seller: May minimize tax liability. | Seller: Real property may be illiquid. | |
| Rights to intellectual property – Franchise | Buyer: Minimizes cash use. | Buyer: Potential for setting up a new competitor. |
| Seller: Gains access to valuable rights, and spreads taxable income over time. | Seller: Illiquid; income taxed at ordinary rates. | |
| Royalties from – Franchises | Buyer: Minimizes cash use. | Buyer: Opportunity cost. |
| Seller: Spreads taxable income over time. | Seller: Income taxed at ordinary rates. | |
| Fee-based – Employment agreement | Buyer: Uses seller’s expertise and removes seller as a potential competitor. | Buyer: May involve demotivated employees. |
| Seller: Augments the purchase price and allows the seller to stay with the business. | Seller: Limits ability to compete in the same business. Income taxed at ordinary rates. | |
| Contingent value rights | Buyer: Minimizes upfront payment. | Buyer: Commits buyer to minimum payout. |
| Seller: Provides for minimum payout guarantee. | Seller: Buyer may ask for purchase price reduction. | |
| Staged or distributed payouts | Buyer: Reduces amount of upfront investment. | Buyer: May result in underfunding of needed investments. |
| Seller: Reduces buyer angst about certain future events. | Seller: Lower present value of purchase price. |
Constructing Collar Arrangements
Unlike all-cash deals, large fluctuations in the acquirer’s share price can threaten to change the terms of the deal or lead to its termination in share-for-share exchanges. Fixed share-exchange agreements, which preclude any change in the number of acquirer shares exchanged for each target share, are commonly used in share exchanges because they involve both firms’ share prices, allowing each party to share in the risk or benefit from fluctuating share prices. The acquirer’s risk is that its shares will appreciate between signing and closing, raising the cost of the deal. The seller’s risk is a drop in the value of the acquirer’s share price, resulting in a lower-than-expected purchase price. While the buyer will know exactly how many shares will have to be issued to complete the deal, the acquirer and the target will be subject to significant uncertainty about the final value of the deal.
Alternatively, a fixed-value agreement fixes the value of the offer price per share by allowing the share-exchange ratio to vary or float. An increase in the value of the acquirer’s share price results in fewer acquirer shares being issued, to keep the value of the deal unchanged, while a decrease would require that additional shares be issued.
Both fixed-value and fixed-share-exchange agreements sometimes include a collar arrangement. For fixed-value agreements, the share-exchange ratio is allowed to vary within a narrow range; for fixed-share-exchange agreements, the offer price per share (deal value) is allowed to fluctuate within narrow limits.34 Collar arrangements can be constructed as follows:
where ASPU > ASPL, SERU < SERL, and subscripts L and U refer to lower and upper limits.
Case Study 11.1 illustrates the use of both fixed value and fixed share exchange agreements. Within the first collar (fixed value), the purchase price is fixed by allowing the share exchange ratio to vary, giving the seller some degree of certainty inside a narrow range within which the acquirer share price floats; the second collar (fixed share exchange) allows the acquirer’s share price (and therefore deal value) to vary within a specific range with both the buyer and seller sharing the risk. Finally, if the acquirer’s share price rises above a certain level, the purchase price is capped; if it falls below a floor price, the seller can walk away. Table 11.4 illustrates the effect of a 1% increase (decrease) in the acquirer’s $11.73 share price on the $6.55 offer price for the target firm’s shares under various collar arrangements.
Case Study 11.1
Flextronics Acquires International Displayworks Using Multiple Collar Arrangements
Key Points
- • Collar arrangements may involve fixed-share-exchange and/or fixed-value agreements.
- • Both buyers and sellers may benefit from such arrangements.
Flextronics, a camera modules producer, acquired International DisplayWorks (IDW), an LCD maker, in a share exchange valued at $300 million. The share-exchange ratio was calculated using the Flextronics average daily closing share price for the 20 trading days ending on the fifth trading day preceding the closing.a Transaction terms included these three collars:
- 1. Fixed-value agreement: The offer price involved an exchange ratio floating inside a 10% collar above and below a Flextronics share price of $11.73 and a fixed purchase price of $6.55 for each share of IDW common stock. The range in which the exchange ratio floats can be expressed as followsb:
If Flextronics’ stock price declines by as much as 10% to $10.55, 0.6209 shares of Flextronics stock (i.e., $6.55/$10.55) is issued for each IDW share.
If Flextronics’ stock price increases by as much as 10% to $12.90, 0.5078 shares of Flextronics’ stock (i.e., $6.55/$12.90) is issued for each IDW share.
- 2. Fixed-share-exchange agreement: The offer price involved a fixed exchange ratio inside a collar 11% and 15% above and below $11.73, resulting in a floating purchase price if the Flextronics’s stock increases or decreases between 11% and 15% from $11.73 per share.
- 3. IDW has the right to terminate the agreement if Flextronics’s share price falls by more than 15% below $11.73. If Flextronics’ share price increases by more than 15% above $11.73, the exchange ratio floats based on a fixed purchase price of $6.85 per share.c
Table 11.4
| % Change | Offer price | % Change | Offer price | |
|---|---|---|---|---|
| ($6.55/$11.73) × $11.73 = $6.55 | ($6.55/$11.73) × $11.73 = $6.55 | |||
| Fixed value | 1 | ($6.55/$11.85) × $11.85 = $6.55 | (1) | ($6.55/$11.61) × $11.61 = $6.55 |
| 2 | ($6.55/$11.96) × $11.96 = $6.55 | (2) | ($6.55/$11.50) × $11.50 = $6.55 | |
| 3 | ($6.55/$12.08) × $12.08 = $6.55 | (3) | ($6.55/$11.38) × $11.38 = $6.55 | |
| 4 | ($6.55/$12.20) × $12.20 = $6.55 | (4) | ($6.55/$11.26) × $11.26 = $6.55 | |
| 5 | ($6.55/$12.32) × $12.32 = $6.55 | (5) | ($6.55/$11.14) × $11.14 = $6.55 | |
| 6 | ($6.55/$12.43) × $12.43 = $6.55 | (6) | ($6.55/$11.03) × $11.03 = $6.55 | |
| 7 | ($6.55/$12.55) × $12.55 = $6.55 | (7) | ($6.55/$10.91) × $10.91 = $6.55 | |
| 8 | ($6.55/$12.67) × $12.67 = $6.55 | (8) | ($6.55/$10.79) × $10.79 = $6.55 | |
| 9 | ($6.55/$12.79) × $12.79 = $6.55 | (9) | ($6.55/$10.67) × $10.67 = $6.55 | |
| Fixed SER | 10 | ($6.55/$12.90) × $12.90 = $6.55 | (10) | ($6.55/$10.56) × $10.56 = $6.55 |
| 11 | ($6.55/$12.90) × $13.02 = $6.61 | (11) | ($6.55/$10.56) × $10.44 = $6.48 | |
| 12 | ($6.55/$12.90) × $13.14 = $6.67 | (12) | ($6.55/$10.56) × $10.32 = $6.40 | |
| 13 | ($6.55/$12.90) × $13.25 = $6.73 | (13) | ($6.55/$10.56) × $10.21 = $6.33 | |
| 14 | ($6.55/$12.90) × $13.37 = $6.79 | (14) | ($6.55/$10.56) × $10.09 = $6.26 | |
| 15 | ($6.55/$12.90) × $13.49 = $6.85 | (15) | ($6.55/$10.56) × $9.97 = $6.18 | |
| > 15 | SER floats based on fixed $6.85 | >(15) | IDW may terminate agreement |
M&A Options and Warrants Takeover Strategies
Options and warrants confer the right but not the obligation to buy or sell a security. The price at which they can be bought or sold prior to a specific expiration date is called the exercise or strike price. Warrants tend to have much longer periods between issue and expiration dates than options do, sometimes stretching as long as years rather than months.
Options and warrants can be structured as the mechanism for a takeover of another firm’s shares or assets. Such deals are relatively common in the pharmaceutical, medical devices, and life sciences industries where the value of the target firm is largely unproven or unapproved (by regulators) intellectual property. Options may be applied to acquisitions of firms at various stages of the product life cycle. Options takeover strategies tend to be more common than those employing warrants because of certain potentially adverse tax consequences explained later.
Firms often find themselves without sufficient capital to develop a new product or a business. Other firms looking for growth opportunities may be willing to invest in such firms but may want to ensure that they have the exclusive right to purchase or to the benefits of the product. Selling an option to acquire to an investor may be sufficient to satisfy the needs of both parties. Such deal structures are sometimes called “option to acquire” deals. Options and warrants as takeover strategies are discussed next.
Option Based Takeover Strategies
“Option to acquire” deals often are used to buy startup firms. The acquirer uses this structure to assist the startup in developing a product and successfully bringing it to market by providing financing and other needed resources (e.g., intellectual property, manufacturing facilities, management expertise, etc.). For firms at a later stage of their product life cycle, a firm may see an option to acquire structure as a means of tapping into a growth opportunity or to diversify.
Such strategies are used when the acquirer is unwilling to provide the financing without the assurance that it will have the exclusive right to acquire the target firm at some future date. To implement such a takeover, the option premium paid for an option granted provided by the target firm is generally nonrefundable; and, the potential acquirer may also make an equity investment in the target at some point before the option expires. At the time the option is negotiated, both the acquirer and target firms’ boards and management negotiate a merger agreement. Immediately following the granting of the option to the acquirer, the target shareholders’ approval is solicited and obtained. Without such approval, the acquirer does not have to pay the option fees to the target firm. This source of income is critical to satisfying the target firm’s financing needs. Unexercised options do not convert into target equity. The length of the option period is based on the estimated time to complete the R&D effort which could include regulatory approval.
The option premium is not taxable to the target’s shareholders at the time the option is granted to the acquirer. Rather, it becomes taxable as a capital gain at the time the option is exercised. If the option is not exercised, the premium paid to the target firm becomes taxable to shareholders as a short term gain, usually subject to the shareholders’ ordinary income tax rate.
Warrant Based Takeover Strategies
Because warrants are issued by the target firm, an acquirer purchases a warrant from the target firm to acquire a newly-created special class of target preferred shares at some point in the future. The acquirer pays the target firm what is known as “warrant consideration” (i.e., the purchase price of the warrant). The target firm must change its charter documents to provide that all of its shares other than a newly issued special class of preferred stock will be redeemed by the target at some future point for a previously determined price if the acquirer exercises the warrant. When all other classes of target stock are redeemed, the only remaining shares would be the special class of preferred shares. If the acquirer chooses to exercise their warrants, it automatically owns the target firm. It the warrant is not exercised, the warrant purchase price is not intended to be taxable to the target firm or any shareholders. Unlike the unused option, the unused warrant does not create a tax liability in that the monies provided upfront as warrant consideration can be spent by the firm without creating a tax liability. If a portion of the warrant consideration is paid out to shareholders, those monies are taxable.
Disadvantages of Options and Warrant Takeover Strategies
A major drawback of using either options or warrants is that they are very difficult to value. As noted in Chapter 8, the Black-Scholes model or some variation may be used to value these types of securities. Using this model requires knowing the volatility of the underlying stock or asset, which is unavailable for privately held stock. Under current tax laws, no tax is due on the receipt of the option premium or warrant consideration, but if they cannot be valued, the value of any increase in the shares or asset on which they are based may be taxed as ordinary income.
Form of Acquisition
What acquirers purchase (target stock or assets) and how ownership is transferred from the target to the acquirer is called the form of acquisition. Each form affects the deal structure differently.35
An asset purchase involves the sale of all or a portion of the assets of the target to the buyer or its subsidiary in exchange for buyer stock, cash, debt, or some combination. The buyer may assume all, some, or none of the target’s liabilities. The purchase price is paid directly to the target firm. A stock purchase involves the sale of the outstanding stock of the target to the buyer or its subsidiary by the target’s shareholders. Unlike an asset purchase, the purchase price is paid to the target firm’s shareholders. This is the biggest difference between the two methods, and it has significant tax implications for the seller’s shareholders (see Chapter 12).
A statutory or direct merger involves the combination of the target with the buyer or a subsidiary formed to complete the merger. One corporation survives the merger and the other disappears. The surviving corporation can be the buyer, the target, or the buyer’s subsidiary. Merger terminology usually refers to the bidder as the surviving corporation and to the target as the disappearing corporation. Knowing which company is to survive is critical under merger law because of successor liability. This legal principle states that the surviving corporation receives by operation of law all rights and liabilities of both the bidder company and the target company in accordance with the statutes of the state in which the combined businesses will be incorporated.36 Dissenting or minority shareholders are required to sell their shares, although some state statutes grant them the right to be paid the appraised value of their shares. Stock-for-stock or stock-for-assets deals represent alternatives to a merger.
State statutes usually require shareholder approval by both the bidder and target firms in a merger. However, no acquirer shareholder vote is required if the form of payment is cash, the number of new acquirer shares issued is less than 20% of the firm’s outstanding shares, or if the number of shares previously authorized is sufficient to complete the deal. These exceptions are discussed in more detail later in this chapter. The most important difference between a merger and a stock-for-stock purchase is that the later does not require a target shareholder vote, since target shareholders are giving their assent by willingly selling their shares. By purchasing all of the target’s stock for acquirer stock or at least a controlling interest, the target firm is left intact as a wholly-owned (or at least controlled) subsidiary of the bidder. Table 11.5 highlights the advantages and disadvantages of these alternative forms of acquisition.
Table 11.5
| Alternative forms | Advantages | Disadvantages |
|---|---|---|
| Cash purchase of assets | Buyer • Allows targeted purchase of assets • Asset write-up • May renegotiate union and benefits agreements in the absence of a successor clausea in the labor agreement • May avoid the need for shareholder approval • No minority shareholders | Buyer • Loses NOLsb and tax credits • Loses rights to intellectual property • May require consents to assignment of contracts • Exposed to liabilities transferring with assets (e.g., warranty claims) • Subject to taxes on any gains resulting in asset write-up • Subject to lengthy documentation of assets in the contract |
| Seller • Maintains corporate existence and ownership of assets not acquired • Retains NOLs and tax credits | Seller • Potential double taxation if shell is liquidated • Subject to state transfer taxes • Necessity of disposing of unwanted residual assets • Requires shareholder approval if substantially all of the firm’s assets are sold | |
| Cash purchase of stock | Buyer • Assets/liabilities transfer automatically • May avoid the need to get consents to assignment for contracts • Less documentation • NOLs and tax credits pass to buyer • No state transfer taxes • May insulate from target liabilities if kept as a subsidiary • No shareholder approval if funded by cash or debt • Enables circumvention of target’s board in hostile tender offer | Buyer • Responsible for known and unknown liabilities • No asset write-up unless 338 election is adopted by buyer and sellerc • Union and employee benefit agreements do not terminate • Potential for minority shareholdersd |
| Seller • Liabilities generally pass to the buyer • May receive favorable tax treatment if acquirer stock received in payment | Seller • Loss of NOLs and tax credits • Favorable tax treatment is lost if buyer and seller adopt 338 election | |
| Statutory merger | Buyer • Flexible form of payment (stock, cash, or debt) • Assets and liabilities transfer automatically, without lengthy documentation • No state transfer taxes • No minority shareholders because shareholders are required to tender shares (minority freeze-out) • May avoid shareholder approval | Buyer • May have to pay dissenting shareholders’ appraised value of stock • May be time consuming because of the need for target shareholder and board approvals, which may delay closing |
| Seller • Favorable tax treatment if the purchase price is primarily in acquirer stock • Allows for continuing interest in combined companies • Flexible form of payment | Seller • Target firm often does not survive • May not qualify for favorable tax status | |
| Stock-for-stock transaction | Buyer • May operate target company as a subsidiary • See purchase of stock above | Buyer • May postpone realization of synergies • See purchase of stock above |
| Seller See purchase of stock above | Seller See purchase of stock above | |
| Stock-for-assets transaction | Buyer | Buyer • May dilute buyer’s ownership position • See purchase of assets above |
| Seller See purchase of assets above | Seller See purchase of assets above | |
| Staged transactions |
a If the employer and union negotiated a “successor clause” into their collective bargaining agreement covering the workforce in the target firm, the terms of the agreement may still apply to the workforce of the new business.
b Net operating loss carryforwards or carrybacks.
c In Section 338 of the US tax code, the acquirer in a purchase of 80% or more of the stock of the target may elect to treat the acquisition as if it were an acquisition of the target’s assets. The seller must agree with the election.
d Minority shareholders in a subsidiary may be eliminated by a “back-end” merger following the initial purchase of target stock. As a result, minority shareholders are required to abide by the majority vote of all shareholders and to sell their shares to the acquirer. If the acquirer owns more than 90% of the target’s shares, it may be able to use a short-form merger, which does not require any shareholder vote.
Purchase of Assets
In an asset purchase, a buyer acquires all rights a seller has to an asset for cash, stock, or some combination. An asset purchase may be the most practical way to complete the transaction when the acquirer is interested only in a product line or division of the parent firm with multiple product lines or divisions that are not organized as separate legal subsidiaries. The seller retains ownership of the shares of stock of the business. Only assets and liabilities identified in the agreement of purchase and sale are transferred to the buyer.
In a cash-for-assets acquisition, the acquirer pays cash for the seller’s assets and may choose to accept some or all of the seller’s liabilities.37 Seller shareholders must approve the transaction whenever the seller’s board votes to sell all or “substantially all” of the firm’s assets and the firm is liquidated. After paying for any liabilities not assumed by the buyer, the assets remaining with the seller and the cash received from the acquiring firm are transferred to the seller’s shareholders in a liquidating distribution.38 In a stock-for-assets transaction, once approved by the seller’s board and shareholders, the seller’s shareholders receive buyer stock in exchange for the seller’s assets and assumed liabilities. In a second stage, the seller dissolves the corporation following shareholder ratification of such a move, leaving its shareholders with buyer stock.
Advantages and Disadvantages From the Buyer’s Perspective
Advantages to the buyer include being able to be selective as to which target assets to purchase and not being responsible for the seller’s liabilities unless assumed under the contract. However, the buyer can be held responsible for certain liabilities, such as environmental claims, property taxes, and, in some states, substantial pension liabilities and product liability claims. To protect against such risks, buyers usually insist on indemnification that holds the seller responsible for payment of damages resulting from such claims.39 Another advantage is that asset purchases enable buyers to revalue acquired assets to market value under the purchase method of accounting (see Chapter 12). This increase in the tax basis of the acquired assets to fair market value provides for higher depreciation and amortization expense deductions for tax purposes. Absent successor clauses in the contract, the asset purchase results in the termination of union agreements if less than 50% of the workforce in the new firm is unionized, thereby providing an opportunity to renegotiate agreements viewed as too restrictive.
Among the disadvantages to a purchase of assets is that the buyer loses the seller’s net operating losses and tax credits, and rights to assets such as licenses, franchises, and patents cannot be transferred, which are viewed as owned by the target shareholders. The buyer often must seek the consent of customers and vendors to transfer existing contracts to the buyer. The transaction often is more complex and costly, because acquired assets must be listed in appendices to the definitive agreement, the sale of and titles to each asset transferred must be recorded, and state title transfer taxes must be paid. Moreover, a lender’s consent may be required if the assets to be sold are being used as collateral for loans.
Advantages and Disadvantages From the Seller’s Perspective
Among the advantages, sellers are able to maintain their corporate existence and thus ownership of tangible assets not acquired by the buyer and of intangible assets such as licenses, franchises, and patents. The seller retains the right to use all tax credits and accumulated net operating losses to shelter future income from taxes. The disadvantages include the potential double taxation of the seller. If the tax basis in the assets is low, the seller may experience a sizeable gain on the sale; if the corporation subsequently is liquidated, the seller may be responsible for the recapture of taxes deferred as a result of the use of accelerated rather than straight-line depreciation. If the number of assets transferred is large, the amount of state transfer taxes may become onerous. Whether the seller or the buyer actually pays the transfer taxes or they are shared is negotiable.
Purchase of Stock
In cash-for-stock or stock-for-stock transactions, the buyer purchases the seller’s stock directly from the seller’s shareholders. For a public company, the acquirer would make a tender offer, because public-company shareholders are likely to be too numerous to deal with individually. A purchase of stock is the approach most often taken in hostile takeovers. If the buyer is unable to convince all of the seller’s shareholders to tender their shares, then a minority of seller shareholders remains outstanding. The target firm would then be viewed as a partially owned subsidiary of the acquiring company. No seller shareholder approval is required in such transactions because the seller’s shareholders are expressing approval by tendering their shares.
Advantages and Disadvantages From the Buyer’s Perspective
Advantages include the automatic transfer of all assets with the target’s stock, the avoidance of state asset transfer taxes, and the transfer of net operating losses and tax credits to the buyer. The purchase of the seller’s stock provides for the continuity of contracts and corporate identity. However, the consent of some customers and vendors may be required before a contract is transferred if it is stipulated in the contract. While the acquirer’s board normally approves any major acquisition, approval by shareholders is not required if the purchase is financed with cash or debt. If stock that has not yet been authorized is used, shareholder approval is required.
Among the disadvantages, the buyer is liable for all unknown, undisclosed, or contingent liabilities. The seller’s tax basis is carried over to the buyer at historical cost40; therefore, there is no step-up in the cost basis of assets, and no tax shelter is created. Dissenting shareholders in many states have the right to have their shares appraised, with the option of being paid the appraised value of their shares or remaining minority shareholders. The purchase of stock does not terminate existing union agreements or employee benefit plans. The existence of minority shareholders creates significant administrative costs and practical concerns.41
Advantages and Disadvantages From the Seller’s Perspective
Sellers often prefer a stock purchase to an asset purchase because the seller is free of future obligations, because all liabilities transfer to the buyer, and the seller is able to defer paying taxes if payment is mostly buyer stock. Disadvantages for the seller include the inability to retain certain assets and the loss of net operating losses, tax credits, and intellectual property rights.
Mergers
In a merger, two or more firms combine, with only one surviving. Unlike purchases of target stock, mergers require approval of both the target’s and acquirer’s boards and are subsequently submitted to both firms’ shareholders for approval. However, there are some exceptions for acquirers, which are addressed later in this chapter. Usually a simple majority of all the outstanding voting shares must ratify the proposal, which is then registered with the appropriate state authority. Such deal structures are sometimes called one-step or long-form mergers.
Statutory and Subsidiary Mergers
In a statutory merger, the acquiring company assumes the assets and liabilities of the target in accordance with the statutes of the state in which the combined firms will be incorporated. A subsidiary merger involves the target’s becoming a subsidiary of the parent. To the public, the target firm may be operated under its brand name but will be owned and controlled by the acquirer. Most mergers are structured as subsidiary mergers in which the acquiring firm creates a new corporate subsidiary that merges with the target.
Statutory Consolidations
Technically not a merger, a statutory consolidation requires all legal entities to be consolidated into a new company, usually with a new name, whereas in a merger either the acquirer or the target survives. The new corporate entity created as a result of consolidation assumes ownership of the assets and liabilities of the consolidated organizations. Stockholders in merged companies typically exchange their shares for shares in the new company.
Mergers of Equals
A merger of equals is a deal structure usually applied whenever the participants are comparable in size, competitive position, profitability, and market capitalization—which can make it unclear whether one party is ceding control to the other and which party provides the greater synergy. Consequently, target firm shareholders rarely receive any significant premium for their shares. The new firm often is managed by the former CEOs of the merged firms as coequals and for the new firm’s board to have equal representation from the boards of the merged firms. However, it is relatively uncommon for the ownership split to be equally divided.42 In mergers of equals, each firm’s shareholders exchange their shares for new shares in the combined firms. The number of new company shares each shareholder receives depends on the desired pro forma ownership distribution in the new company after closing and the relative contribution to potential synergy contributed by each firm.
Actual mergers of equal are rare. To reach agreement, one firm will acquire another and in the merger agreement stipulate the takeover as a merger of equals even when the target is in reality ceding control to the acquirer. Why the charade? Being taken offer often has negative connotations. So making it appear that both firms are equal “partners” in the deal, makes the transaction more acceptable to the target’s board and senior managers.
Such deals are more likely to work if both parties to the deal are highly motivated by what they believe are substantial and realizable synergies. In late 2013, Office Depot, Inc. and OfficeMax Inc. completed their $18 billion merger of equals, with the combined firms using the name Office Depot. Anticipated cost synergies could total $1–$2 billion annually. Neil Austrian, Chairman and CEO of Office Depot, and Ravi Saligram, President and CEO of OfficeMax, will serve as co-CEOs. In addition to Austrian and Saligram, the new firm’s board will consist of five independent directors from each of the Office Depot and OfficeMax boards. Such deals can, however, create impossible hurdles because of the lack of one party being clearly in control. Billed as a merger of equals, the $35 billion merger of US-based Omnicom and France’s Publicis collapsed after a battle over how the firm would be organized destroyed plans to create the world’s largest advertising agency.
Tender Offers
An alternative to a traditional one-step (or long-form) merger is the two-step merger. In the first step, the acquirer buys through a stock purchase the majority of the target’s outstanding stock from its shareholders in a tender offer; in the second step, a squeeze-out/freeze-out merger or back-end merger is approved by the acquirer as majority shareholder. Minority shareholders are required to tender their shares. While such shareholders generally receive cash, preferred stock or debt for their shares as part of the transaction, they would no longer retain their minority ownership stake.
The two-step merger usually is faster (if the buyer can get enough votes in the tender offer to qualify for a short-form merger) than the more traditional one-step merger which requires shareholder approval (with some exceptions) by both acquirer and target shareholders. The one-step merger process may take several months to close as a proxy statement must be prepared and reviewed by the SEC, mailed to shareholders, and a shareholder vote must be obtained. The lengthy process creates uncertainty due to possible competing bids.
An important disadvantage of the two-step merger in the past has been the delay and cost of consummating the back-end merger necessary to acquire the shares that were not purchased in the initial tender offer. If the buyer failed to own 90% of the target’s stock after the tender, the buyer was not permitted to use a short-form merger which requires a target board but not shareholder approval. Instead the buyer had to prepare, file and mail a proxy statement following SEC review and hold a stockholder meeting. This process could result in a two-step merger taking longer than a one-step merger. Buyers and sellers have utilized a number of negotiated contract provisions to limit the risk of a protracted back end merger. These included the top up option and dual track structure discussed in more detail later in this chapter.
In late 2013, Delaware General Corporation Law was amended to include Section 251(h) permitting backend mergers under certain conditions to be completed following a tender offer enabling the buyer to acquire at least enough target shares to approve the merger (but less than the 90% required to use a “short form” merger). This means that backend mergers can now be implemented without the lengthy and costly process described previously.
To qualify for the accelerated backend Section 251(h) merger process, several conditions must be satisfied. The target must be listed on a national public exchange with at least 2000 shareholders and the buyer must be a corporation; the target’s certificate of incorporation must not require shareholder approval for mergers; and the merger agreement must have been signed after August 1, 2013 and stipulate a provision requiring a backend merger as soon as practicable following the tender offer. Following the tender offer, the buyer must own at least the number of target shares required to adopt the merger agreement, usually a simple majority; the consideration in the second step must be in the same amount and form as paid to shareholders in the first step; and no single target shareholder when the merger agreement is approved by the target’s board may own 15% or more of the target’s shares.
While Section 251(h) of Delaware General Corporate Law makes the two-step merger more attractive for M&A deals involving public companies, one-step (long-form) mergers may still make sense in other instances. Deals subject to extensive regulatory review and delay may benefit from the one-step process in which shareholder approval is obtained as soon as possible rather than allowing a tender offer to be subject to the receipt of regulatory approval. The shareholder approval eliminates the ability of the target’s board to accept a competing bid. With a tender offer contingent on receiving approval by regulators, the target’s board could accept competing bids. Other instances include the target’s charter requiring a shareholder vote on all merger deals and when the target’s shares are not publicly traded.
Shareholder Approvals
Target shareholders usually must give consent if all or “substantially all” of the firm’s assets are being acquired.43 While no acquirer shareholder vote is mandatory when the form of payment is cash because there is no dilution of current shareholders, there are certain instances in which no vote is required by the acquirer’s shareholders in share-for-share exchanges. The first, the so-called small-scale merger exception, involves a transaction not considered material.44 The second, a short-form merger or the parent-submerger exception, occurs when a subsidiary is being merged into the parent and the parent owns a substantial majority (over 90% in some states) of the subsidiary’s stock before the transaction. The third exception involves use of a triangular merger, in which the acquirer establishes a merger subsidiary in which it is the sole shareholder. The only approval required is that of the board of directors of the subsidiary, which may be the same as that of the parent or acquiring company.45 Finally, no shareholder approval is needed if the number of shares previously authorized under the firm’s articles of incorporation is sufficient to complete the deal.
Top-Up Options and Dual Track Deal Structures
Such options are granted by the target to the bidding firm, whose tender offer is short of the 90% threshold to qualify as a short-form merger, to buy up newly issued target shares to reach the threshold. Since the option ensures that the merger will be approved, the bidder benefits by avoiding the delay associated with back-end mergers requiring a shareholder vote if the acquirer is unable to get enough target shares to implement a short-form merger. The target firm benefits by eliminating potential changes in the value of the bidder’s shares that are offered in exchange for target shares that could occur between signing and closing.
Dual track deal structures include both a two-step tender offer and the simultaneous filing of preliminary proxy materials for a one-step merger. The intent is to hedge against the risk of a delayed backend merger if the tender offer does not reach 90%. The dual track structure can be just as time consuming and expensive as using a tender offer in the first step and a long-form merger in the second step.
Special Applications of Basic Structures
While the one-step (long-form) merger deal structure is still an option, the two step merger has become increasingly popular in leveraged buyouts (LBOs) due to the expectation that such deals can be closed faster. A financial sponsor (equity investor) or buyout firm creates a shell corporation funded by equity provided by the sponsor. After raising additional cash by borrowing from banks and selling debt to institutional investors, the shell corporation buys at least 90% of the target’s stock for the deal to qualify as a short-form merger, squeezing out minority shareholders with a back-end merger.46 Following the 2013 changes in Delaware law described previously, the LBO buyout firm may qualify for an expedited backend merger. Such tactics are employed when the industry in which the target firm competes is believed to be undervalued in order to acquire the firm at a discount from its fair market value.47
Single-firm recapitalizations are undertaken by controlling shareholders to squeeze out minority shareholders. To do so, a firm creates a wholly owned shell corporation and merges itself into the shell in a statutory merger. Stock in the original firm is cancelled, with the majority shareholders in the original firm receiving stock in the surviving firm and minority shareholders receiving cash or debt.48 In early 2014, the Delaware Supreme Court ruled in Kahn v. M&F Worldwide Corp. that a freeze-out merger between a controlling shareholder and its minority shareholders should be reviewed under the “business judgment rule” if certain procedures are followed with the burden of proving unfair treatment or valuation on minority shareholders.”49 These procedures include the following: the controlling shareholder relies on the advice of a special committee of the board established to review such proposals and a fully informed and without duress vote of a majority of the minority shareholders. If neither procedure is followed, the legality of the squeeze out merger will be subject to a more rigorous standard than the business judgment rule: that is the entire fairness standard, sometimes referred to the unified fairness standard. Under this standard, the burden is on the controlling shareholder to prove that the squeeze-out was undertaken for a legitimate business purpose, the price offered for minority shares is fair,50 and all dealings with minority shareholders are fair.
Staged transactions involve an acquirer’s completing a takeover in stages spread over an extended period of time. They may be used to structure an earnout, enable the target to complete the development of a technology or process, or await regulatory approval of a license or patent.
Some Things to Remember
Deal structuring entails satisfying the key objectives of the parties involved and how risk will be shared. The process defines initial negotiating positions, risks, options for managing risk, levels of risk tolerance, and conditions under which the buyer or seller will “walk away” from the deal.
Chapter Discussion Questions
- 11.1 What are the advantages and disadvantages of a purchase of assets from the perspective of the buyer and the seller?
- 11.2 What are the advantages and disadvantages of a purchase of stock from the perspective of the buyer and the seller?
- 11.3 What are the advantages and disadvantages of a statutory merger?
- 11.4 What are the reasons acquirers choose to undertake a staged or multistep takeover?
- 11.5 What forms of acquisition represent common alternatives to a merger? Under what circumstances might these alternative structures be employed?
- 11.6 Comment on the following statement: A premium offered by a bidder over a target’s share price is not necessarily a fair price; a fair price is not necessarily an adequate price.
- 11.7 In a year marked by turmoil in the global credit markets, Mars Corporation was able to negotiate a reverse breakup fee structure in its acquisition of Wrigley Corporation. This structure allowed Mars to walk away from the transaction at any time by paying a $1 billion fee to Wrigley. Speculate as to the motivation behind Mars’ and Wrigley’s negotiating such a fee.
- 11.8 Despite disturbing discoveries during due diligence, Mattel acquired The Learning Company, a leading developer of software for toys, in a stock exchange valued at $3.5 billion. Mattel had determined that TLC’s receivables were overstated because product returns from distributors were not deducted from receivables and its allowance for bad debt was inadequate. Also, a $50 million licensing deal also had been prematurely put on the balance sheet. Nevertheless, driven by the appeal of becoming a big player in the children’s software market rapidly, Mattel closed on the transaction, aware that TLC’s cash flows were overstated. Despite being aware of extensive problems, Mattel proceeded to acquire The Learning Company. Why? What could Mattel have done to protect its interests better? Be specific.
- 11.9 Describe the conditions under which an earnout may be most appropriate.
- 11.10 Deutsche Bank announced that it would buy the commercial banking assets (including a number of branches) of the Netherlands’ ABN Amro for $1.13 billion. What liabilities, if any, would Deutsche Bank have to (or want to) assume? Explain your answer.
Solutions to these Chapter Discussion Questions are found in the Online Instructor’s Manual for instructors using this book (https://textbooks.elsevier.com/web/Manuals.aspx?isbn=9780128150757).
US-based chemical conglomerates Dow Chemical Inc. (Dow) and E.I. du Pont de Nemours and Company (DuPont) merged to form DowDuPont on September 1, 2017. DowDuPont is the second largest chemical company in the world, behind BASF of Germany, with more than $92 billion in annual revenue. Originally announced on December 11, 2015, the ultimate goal of the merger was to restructure the combined firms into three focused businesses, achieve billions in cost savings, and to subsequently spin them off tax-free to shareholders.
In an attempt to gain the support of activist investors, DowDuPont announced a revised restructure plan less than two weeks after the formation of the new firm. The change was a result of an extensive 4-month portfolio review undertaken by McKinsey and Company that culminated in an effort to ensure that each business would be more focused on its target markets. DowDuPont is not alone in bowing to investor activist demands in recent years. Activists have been targeting ever larger firms demanding changes to their business strategies. Procter & Gamble, Nestle, and Samsung have all been in their sights in recent years.
The revised plan is substantially similar to the earlier version which called for breaking the firm into three businesses: one making plastics and materials, one in agricultural chemicals and seeds, and one making a range of specialty products. What changed was the allocation of the product lines within these businesses. Seven businesses originally intended to be included in Material Sciences will instead be included in Specialty Products. The reallocated businesses accounted for more than $8 billion in revenue and $2.4 billion in earnings before interest, depreciation and amortization in 2017. The justification for the move was to ensure that Material Sciences, which will maintain the Dow brand name, would not be focused on plastics and petrochemicals. The Agriculture business would remain the same. After this realignment, the new Material Science business (Dow) would have about $40 billion in annual revenue; the Specialty Products business about $21 billion in yearly sales; and the Agriculture business about $14 billion in annual sales. This reconfiguring of the original plan gained the support of the dissident activist investor groups: Trian Partners, Third Point, and Glenview Management.
The motivation for combining Dow and DuPont reflected a combination of factors including the effects of slumping commodity prices, weak demand for agricultural chemicals, and headwinds from a stronger dollar. By combining the firms, a common board and management could reorganize the various product lines into businesses that were more clearly focused on a common set of target markets, realizing substantial ongoing cost savings by eliminating duplicate overhead, and growing sales by increasing penetration in targeted markets.
Dow is known for plastics and agricultural chemicals and DuPont for technical innovations as Kevlar and Teflon. DuPont has suffered from intense competition in agriculture from Monsanto, especially in its corn seed business. In addition to agriculture, the firm’s business portfolio included electronics and communication, and complex materials. Dow Chemical’s business portfolio was divided into two groups: specialty and basic chemicals. The firm has increased its focus on specialty chemicals which carry higher prices than basic chemicals whose profitability is subject to the volatility of the energy markets.
The combination of Dow and DuPont was billed as a merger of equals. Under the terms of the transaction, Dow shareholders received a fixed exchange ratio of one share of DowDuPont for each Dow share, and DuPont shareholders would receive a fixed exchange ratio of 1.282 shares in DowDuPont for each DuPont share. At closing, Dow and DuPont shareholders would each own approximately 50% of the combined company. DuPont’s Chair and CEO Edward Breen would retain his title at the new firm, while Dow’s CEO Andrew N. Liveris would become Executive Chairman of the combined companies. The new firm’s board would consist of 16 directors, consisting of 8 incumbent DuPont directors and 8 current Dow directors.
Implementing the breakup strategy is subject to numerous challenges. Reorganization involves moving people around, trimming overhead, allocating debt, renegotiating customer and supply agreements, disentangling jointly used information technology systems, and ensuring that the eventual spun off units would be considered tax free by the IRS to shareholders. The logistics of such activities often take many months and DowDuPont expected to implement three spin offs in a relatively short period of time (18–24 months). DuPont’s last spinoff, Chemours, a performance chemicals unit, has been a disaster. Weighed down by debt and falling commodity prices, the business lost three-quarters of its value in less than a year after its separation.
With a total workforce exceeding 100,000 people, the major task confronting the new firm will be in retaining and keeping motivated talented people. While it is customary to use retention bonuses to keep those workers needed during the transition period leading up to the spinoffs, the resulting uncertainty, stress, anger, frustration, and confusion are likely to result in significant attrition. While such attrition may be desired from a cost savings standpoint, some of those employees leaving will be critical for the ongoing operations of the business. In businesses that have been as integrated as Dow and DuPont, layers of management will be stripped away. Management turnover typically tends to be substantially higher during this period leading to confusion among reporting relationships and disjointed communication. Also, it is likely that management will be stretched thin as executives are asked to maintain or improve the performance of their business units while implementing the logistics required for the spinoffs.
Tax considerations were critical to the deal. The tax-free treatment of the spin-offs is viewed as a highly attractive alternative to selling selected businesses which could result in significant taxable gains to Dow and DuPont. Structured as a merger of equals in a share for share exchange, the DowDuPont deal also is tax free to shareholders. Typically, companies that have been through a change of control are liable to pay capital gains taxes on subsequent spin-offs, under section 355 of the US Internal Revenue Code (see Chapter 16 for more detail). If both companies, however, do not formally undergo a change of control, the spin-offs can be tax-free. After their merger, Dow and DuPont plan to argue that no change of control will have occurred by structuring their initial deal as a merger of equals. Bolstering their view that a change of control has not occurred is that the two companies have many shareholders in common. Vanguard Group Inc., State Street Global Advisors, Capital World Investors and BlackRock Inc. are, in that order, the top holders of both companies’ stock.51
Separating a unit from the parent is fraught with issues and risks; separating multiple units concurrently compounds the problems. Finance-related issues include determining the desired debt to total capital ratio for each of the three business units, deciding which nonlong-term debt related liabilities will go with each spin-off company, and how best to maintain the solvency of the newly independent businesses. Other critical execution issues are determining the appropriate governance mechanism (i.e., management structure, centralized versus decentralized control, culture, etc.) for each new unit and how best to address human resource issues.
Complexities arise when the unit has formal relationships with other operating units including sharing common support functions such as finance, human resources, and accounting and intracompany purchase or sale arrangements. No one unit should be overburdened with debt and each business should have sufficient cash on hand to remain solvent. A common strategy is for the spin-off company to issue new debt prior to the spin-off with the cash proceeds use to pay off any long-term debt and liabilities not allocated to any of the three businesses.
When a subsidiary has been operated as a standalone business, its current management usually becomes the management team after the spin-off and its employees generally remain with the spin-off company. In spin-offs of divisions that have not been operated on a standalone basis, management issues are more challenging. Existing managers of the spin-off company often have responsibilities that overlap with operations that have been allocated to other spin-off companies.
Ultimately, the success or failure of the DowDuPont breakup strategy may rest on the competitive conditions and growth outlook for the markets served by each of the three businesses. Each business competes in commodity markets: those characterized by cyclical demand and intense price competition. Enabling each of the businesses to cut costs will allow for some margin improvement, assuming unchanged selling prices. More focused businesses can enable management to make more rapid and more informed decisions resulting in aggressive exploitation of emerging opportunities. But history shows that the simple act of breaking up a firm does not ensure improved shareholder value. Breakup strategies which look good on paper often fail to realize their potential. Why? While increased focus and cost cutting help, the basic dynamics of the industry remain unchanged. Highly competitive industries remain so and tend to limit financial returns to those commensurate with the risk associated with the industry.
Discussion Questions
- 1. In what way have activist investors assumed the role of hostile takeovers in influencing managers of underperforming firms?
- 2. Do you think that the restructuring strategy set in motion with the creation of DowDuPont makes sense? What alternative was available to both Dow and DuPont had they remained independent? Be specific.
- 3. Speculate as to why the deal was structured as a merger of equals. What are the advantages and disadvantages of such a structure? Be specific.
- 4. What are the key assumptions DowDuPont is making in arguing the merger followed by the spin-off of three businesses makes sense?
- 5. What is the form of payment and the form of acquisition used in this deal? What are the advantageous and disadvantageous of the form of payment and acquisition used in this deal?
- 6. Dow shareholders will receive a fixed exchange ratio of one share of DowDuPont for each Dow share, and DuPont shareholders will receive a fixed exchange ratio of 1.282 shares in DowDuPont for each DuPont share. Dow and DuPont shareholders will each own approximately 50% of the combined company, excluding preferred shares. Common shares outstanding at Dow and DuPont at the time of the announcement were 1.160 billion and 0.876 billion, respectively. Using this information, show how the postclosing ownership distribution can be determined. How might these fixed share exchange ratios have been determined during the negotiation of the deal?
- 7. Dow’s price per share on December 11, 2015 was $54.91 and DuPont’s was $74.55. Dow shares outstanding were 1.160 billion and DuPont’s outstanding shares were 0.876 billion. Assume anticipated annual cost synergies are $3.0 billion in perpetuity and that DowDuPont’s cost of capital is 10%. What is DowDuPont’s total market cap excluding synergy? What is the market cap including synergy using the zero growth method of valuation (see Chapter 7)?
Solutions to these questions are provided in the Online Instructor’s Manual for instructors using this book (https://textbooks.elsevier.com/web/Manuals.aspx?isbn=9780128150757).